India’s central bank looking forward to drop in gold price after decade of ‘panic’ buying. Huh?

A new study by India’s central bank asks whether gold bullion as a safe haven investment has turned into an asset bubble and crucially, if that bubble should burst, would the subcontinent’s financial system experience systemic damage.

The Reserve Bank of India study speculates that “perhaps the unabated rise in the international gold prices since 2003 which have further gained pace in recent months are a result of ‘panic buying’.”

The authors conclude “a sharp reversal in gold prices would in fact be reflective of improvement in global conditions, especially, those in the US. The substitution of gold for equity and other riskier assets would thus offset the systemic impact of gold prices, if any.”

Another mitigating factor for the Indian economy should the gold price fall is that the country’s banks are not overly exposed to gold (compared to the sub-prime mortgage crisis in the US for instance) and if the bursting of an asset bubble is not accompanied by a banking crises the risks to the economy are minimized:

Some boom-bust cycles, such as those in Japan and Scandinavian countries in the 1990s, and the sub-prime crisis of 2007-2009, led to banking crises and a severe recession. But on well known occasions such as 1987 stock market crash or the dot-com bubble of 1999-2000, the collapse of asset price did not result in any banking crisis.

However, the influential Hindu Business Line business paper points out significant driving forces in the market that the central bank may have overlooked and that could come back to haunt the authors:

And what about the gold loan industry which has been growing by leaps and bounds in recent years?

Yes, Indian banks may not directly hold much gold today. But they are lining up significant forays into the highly profitable gold lending business.

In doing this, they are taking a leaf out of the books of large NBFCs [non-bank financial companies], which have popularised organised gold lending.

According to the research by Australia’s Macquarie, Indian households are hoarding 18,000 metric tonnes of gold worth over $950 billion, representing 50% of the country’s GDP.

These figures have prompted some to argue that gold’s central role in Indian culture could be harming the economy with the FT writing that “the vast amounts of gold widens the country’s current account deficit, weakens the rupee and generally keeping money that could flow into the economy locked up in cupboards and jewellery boxes.”

Continuing this line of thinking, the new central bank study would in fact welcome a fall in the price of gold which it says would free up funds for more productive investments in the Indian economy.

Indian households own 11% of the global total and it is estimated that 7% – 8% of India’s 329 million households held their savings in gold in 2009 – 2010.

According to the World Gold Council half of all gold holdings are in the form of jewellery. The Business Standard reported over the weekend now that platinum trades more in line with the gold price, Indian jewellery buyers are moving back into gold.

Platinum traded as low as $1,400 an ounce at the end of last year and prompted Indian consumers to push the share of ‘white gold’ to as high as 30% of the jewellery market.

It has has now returned to historical levels of 15% because apart from deep cultural attachments, gold is also preferred over platinum because the latter precious metal can sometimes be mistaken for much cheaper silver.

The RBI study comes after a turbulent week on the gold market. Last week gold registered its worst weekly performance for 2012 after a sustained rally in January and most of February.

The losses came after a dramatic trading day on Wednesday when the yellow metal lost almost $80/oz in an hour after a single sale order of 1 million ounces or 31 tonnes.

Analysts say this week could be a crucial test for the yellow metal and a significant break below the $1,700 level could trigger a major sell-off.

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